First Eagle Investment Management – An Investor’s Perspective On Brexit
H/T Dataroma
The common wisdom among analysts at this writing is that British voters will choose to stay in the European Union (EU) when they cast their ballots on June 23, and bookies presently see this outcome as a 66% probability.1 Nevertheless, recent public polls suggest that the vote could be quite close, with the difference between the “Leave” and “Remain” camps within the polls’ margin of error. In this commentary, Senior Sovereign Analyst Idanna Appio reflects on the potential impact of a “Leave” decision on both the UK and the EU.
Q: In the short term, how do you think a Leave vote would affect the British economy?
The possibility of a Leave vote is already having an impact. Consumption and investment indicators have slowed as firms delay their investment plans. House prices have taken a pause, as consumers put off big decisions while they wait for the vote.
If, in fact, British voters choose to exit the EU, the market reaction could be quite severe. The EU is Britain’s largest trading partner, and the future of this relationship would be uncertain for an extended period of time. Equity markets might slide. Mark Carney, governor of the Bank of England, says Brexit could trigger a recession in the UK—a possibility that might drive gilt yields lower.
The British pound might also decline. The UK runs a large current account deficit and finances it with foreign direct investment (FDI). Britain is a magnet for foreign companies in part because it is a gateway to the EU. If that ceases to be the case, some companies might be less eager to base themselves in London. If FDI declines, the UK might need a cheaper currency to narrow its current account deficit.
Q: What kind of impact do you foresee for the EU?
In the short term, the EU could experience less of a direct market reaction, but no country has ever left the EU and having the second-largest country exit could feed into other political concerns. Seen as a rejection of the EU, a Leave vote could add to the populist and disintegrating pressures that have appeared across Europe. People haven’t been as concerned about the stability of the euro area for about a year now, but these concerns could resurface, particularly with Spanish elections on June 26 and a constitutional referendum in Italy in October.
The EU could also lose some of the more market-friendly pressure it receives from the UK. For example, it’s the British who have been driving the EU’s initiative for a capital-markets union, and the UK has also pushed for a more open market for services. Without having this push, all else equal, growth could be slower in the EU.
Q: Over the longer term, how might a Leave vote affect the UK economy?
This will depend on what kind of relationship the UK is able to negotiate with the EU. If they vote to leave, the British will have to develop a new arrangement with the EU, and all 27 of the remaining member states will have to approve it. In addition, the EU currently has trade deals with 60 countries, and the UK will have to negotiate terms with all of them. These processes could be lengthy.
There are three existing models for the UK’s future relationship with the EU: Norway, Switzerland and Canada. However, these countries do not have the same access to the common market and level playing field that the UK currently enjoys. They have no votes on EU laws, and Norway and Switzerland still contribute to the EU budget.
While it’s true that both the UK and the EU would have incentives to come to some beneficial agreement, the EU does not want other countries to depart, and it may hesitate to accommodate British preferences. Further complicating the process is the question of who will conduct these negotiations. On the UK’s side, if there’s a vote to leave, David Cameron will no longer be prime minister. There will be a vote within the Conservative Party for a new prime minister, and it’s unclear who would win. If a Euro-skeptic is elected, the negotiations on Britain’s relationship with the EU could be more confrontational. Germany and France will hold elections in 2017, and their political processes could further delay negotiations with the UK. I believe that uncertainty will remain high for a number of years and that there could be negative headlines back and forth during the negotiations.
In terms of costs, the Organisation for Economic Co-operation and Development (OECD) has estimated that the level of the UK’s GDP will be 3% lower by 2020 (£2,200 per household) and 5% lower by 2030.2 The UK Treasury came out with numbers twice as large as these. The OECD estimated smaller costs for the EU—a modest decline of 1% in the level of GDP by 2020.3 But nobody really knows because nobody really knows how the markets will react, how policy will respond, and what the new relationship will be between the UK and the rest of the EU.
Q: Could a Leave vote affect the independence movements that have surfaced within the UK?
This is a possibility. The Scottish independence movement has suffered in the polls recently and probably would not push for a new referendum right now, but if a new relationship between the UK and EU leads to worse access for Scottish goods and services than previously, Scotland could decide to hold another referendum. It would also be very awkward if tariffs suddenly appeared between Northern Ireland and Ireland. And there could also be independence pressure in Wales, which receives substantial EU transfers. Brexit could end up challenging the UK’s survival as a nation-state.
Q: Do you anticipate any positive outcomes from a Leave vote?
In the short run, one possible benefit for the UK could be a cheaper pound, which might help certain companies that are exporters.
Looking out further in time, the UK might benefit from the more flexible regulatory environment that could become possible outside the framework of the EU. Brussels is a large and slow-moving bureaucracy that, for example, has not yet reached trade deals with a number countries, despite years of negotiations. One argument offered for Brexit is that, absent the need for approval by all 28 EU member states, the UK could potentially get these trade deals done much more quickly.
Some people assume that over the longer term, a British exit would be bad for the EU, but this doesn’t have to be the case. If the euro area is ever going to be a fully functional monetary and economic union, I believe that it needs deeper economic, financial and political integration. I think this will probably require a more rational governance structure for the euro area that excludes EU members that maintain their own currencies. The UK is by no means the only stumbling block to a stronger euro area, but it is an obstacle, and Brexit might eventually open the way to further integration on the Continent. But on this and other issues, our crystal ball remains foggy.
Q: If the British choose to exit, what might be the impact on First Eagle’s Global and Overseas Funds?
For a long time, we’ve maintained a neutral hedge on sterling, which was fairly valued according to our currency models. The British pound has become cheaper on our models, but not cheap enough that we would start to reduce our hedge ratio yet. If sterling falls sharply, we might do so. For the euro, we have maintained a low hedge ratio because the currency has appeared undervalued according to our currency model. In the event of a Leave vote, we may want to reconsider our euro hedging strategy.
In terms of other opportunities, there are already some British companies that have started to trade at discounts to our estimates of their intrinsic value. Selectively, our portfolio managers are beginning to build small positions. If there’s an exit vote and stocks get cheaper, we may have opportunities to invest in businesses we believe could be stable in a range of post-Brexit environments.
